On FX intervention and the ECB/SMP

The ECB has been a big player on the buy side of EU bonds. Its intervention topped E200b recently. Of course that’s just a fraction of the supply that is out there. At this point, the ECBs efforts have been a miserable failure. Rather than put a ring fence around critical countries such as Italy, the ECBs tactics have added to the fire.

The ECB is in a bad position. The news flow and large supply have put them on the defensive. Defense is no way to run an intervention policy. At best, it’s slow grind to a loss.

I sat on FX interbank desks in the 70’s and 80’s when the NY Fed came into the FX markets on a regular basis in an effort to stabilize and steer the dollar. The “Stick” (what the Fed was called) was on both the sell and buy side at different times over those years. This was low-tech time. There was a direct telephone wire to the Fed desk. It would light up and they would ask for a price on $100mm USDDM (no Euros then). Dealers are obligated to make prices. You knew you were going to get slammed as soon as they said:

“Done for a 100 mil. We can carry on at that price”.

All hell would break out in the FX markets when the Fed intervened. I would get little sleep for a few days. After about a dozen of these sphincter event I formed my own opinions on how intervention should be conducted. There’s plenty of academic stuff on this too.  The following are considerations when evaluating the efficacy of FX intervention. Some of the lessons apply to the dilemma the ECB finds itself in today.

When confronted with unstable markets where the instability is, by itself, undermining the broader economy, the first objective is to re-establish stability. There is only one way to do that in the short-term. The financial authorities must establish Two Way Risk back into the market. Ideally, the objective is to create as much risk in being long as the risk of being short.

The ECB has failed to establish two-way risk. Virtually every (Italian, etc) bond that has been sold over the last few months has been a “good” sale. There has been no risk to selling, the only risk has been in buying. If the ECB wants to be successful they must create a risk situation that is equally weighted. Call that shock and awe. It has to call the dealers and make them understand sphincter power. (As the Fed did to me.) In my day, the the term “Don’t fight the Fed” came into being because the Fed had learned (after early failures) that it had to be on the offense when it came to intervention.

Of course, it’s not all that easy. Over the years, currency intervention has repeatedly failed. For example, the currency “Peg” or “line in the sand” strategy has had mixed results. The Currency Board ($ peg) in Argentina worked well for a while and then had a spectacular blowup. The Euro countries had numerous devaluations in the years running up to the Euro. (Fixed exchange rates didn’t work then any better than they do today). The best example of a Peg gone bad is when George Soros took out the Bank of England in 1992.

Some pegs have worked. The HK$ is a shining example. However, a peg is not without cost. Hong Kong’s reserves are now $281b. That comes $40,000 per person (just the opposite of the US). The Central Bank has been forced to absorb 9Xs the amount of money in circulation. Switzerland has recently adopted a peg. So far, so good. But they too have had an explosion in reserves. The Swiss are rapidly approaching the nutty levels in HK.

I don’t think pegs are relevant when it comes to options the ECB might consider. If they tried to peg (or even bracket) Spanish or Italian bonds they might get overwhelmed with sellers.

Speaking of being overwhelmed by the market, the experience by the Swiss National Bank (SNB) in 2009 is worth noting as a classic intervention mistake. The SNB tried to hold the EURCHF at 1.500. It was swamped with sellers at that price. In the end, the SNB was forced to fold. The error cost them dearly, both in money and prestige.

This is a real consideration for the ECB. At what price level(s) and under what terms should it use intervention? How do they respond if there is E500b of Italian/Spanish paper on offer and looking for a bid? Some say that 7% Italian bonds already indicate the end is nigh.  I’m not so sure. But if this ratchets up another few levels and Italian yields push 9% the end will be very close indeed.

I’m quite certain the folks at the ECB are aware of this. So is the market. A test of each others will is in the offing. December is a time for things like that to happen.

A final example of flawed intervention is that of the Bank of Japan. Its policy is often referred to as, “Slow death by a thousand swords”. Everyone knows that the best time to sell USDYEN is a few hours after the BoJ makes a splashy intervention. They have been at this for years. It hasn’t worked once. It’s just a source of revenue for the exporters, banks and specs.

This is not a consideration for the ECB. Time is not on its side. Japan’s problem is that too much money is coming in. The ECB is looking at this from the other side of the mirror. The wrong side.

There is no example (other than Hong Kong) where a single central bank has fought the markets and won. Successful intervention has to be coordinated with other central banks and activities by supranational entities (IMF types). This is very important for the ECB. They are alone in this this fight. No one has offered a hand. The “Go it alone” plan won’t work. The markets are much bigger than the ECB.

There is little evidence that currency intervention achieves more than buys time for an inevitable correction. The only evidence of success is that of the US Fed. They succeeded by intervening in a decisive magnitude, and in concert with other central banks.

Its unknown whether historical observations of what has and has not worked to bring stability to the FX markets is relevant to the intervention fight that the ECB finds itself in today. There is no history describing what is unfolding in the EU bond markets. This makes it all the more difficult to forecast what will happen next.

To the extent that the history of FX intervention provides some clues to what is coming, it does not paint a pretty picture. The ECB can’t shock and awe. It has no friends. It’s unable to establish two-way risk. The clock is ticking. It has limited resources. We are already at crisis levels. Further deterioration will accelerate across other markets and broaden the sense of panic.

Did I mention that the ECB knows all this? And that it has no friends?

Yikes!! I posted this and a few minutes later the Fed/other CBs announces a round of coordinated measures to assist the ECB. My point in this article was that the ECB has no friends, and that was the weakest link in their defense of the EU bond market. It seems they now have friends. We shall see how good these “friends” are.

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